Inflation Concerns?…Follow the Trends
Inflation concerns are grabbing a lot of headlines recently as consumers emerge from COVID-19 lockdowns flush with cash. The Federal Reserve maintains that any rise in inflation will be “transitory.” However, prudent investors are right to ask, “Which assets or strategies will best insulate my portfolios from sustained price increases?”
Investors naturally fear deflationary “busts,” such as in 1929 or 2008. However, history suggests that elevated and prolonged periods of inflation are more certain destroyers of multi-generational wealth through the gradual erosion of purchasing power. Most hope to outrun this erosion by compounding their investment portfolio at a rate in excess of inflation such that the asset base grows through time in “real,” or inflation-adjusted, terms. Unfortunately, traditional portfolios (60% stocks/40% bonds) are not well positioned to preserve wealth in inflationary environments. This is particularly true when valuations are high relative to their historical averages.
Inflation is a tricky subject and perhaps the least understood phenomenon in economics. However, it has been empirically observed that rising inflation is challenging for both stocks and bonds. Input cost increases generally outpace most businesses ability to pass through cost to consumers, resulting in compressed profit margins. Rising price levels in the economy also degrade the purchasing power of principal and interest payments of fixed income assets, causing bonds to lose value in real terms. One of the only bright spots in inflationary environments tends to be commodities, an asset class underutilized by most investors.
Enter… Trend Following
Trend following, often referred to as “managed futures,” is a dynamic strategy offering portfolios substantial diversification benefits. This systematic or “rules-based” strategy is tailor-made to profit from major moves in global markets. Such outsized market trends often materialize during times of, or as a result of, changes in inflationary regimes.
Trend followers typically trade all major asset classes (stocks, bonds, currencies and commodities), and do so in a balanced, risk-controlled manner without a bias to be long or short. The strategy uses price data to understand market direction and positions to capitalize from continuations in recent trends. Time-series momentum, as it’s called in academic circles, is one of the most ubiquitous market anomalies for a host of structural and psychological reasons, but the major takeaway is that trend followers are nearly always on the right side of history when decade-defining market trends occur.
A team of researchers from Man Group and Duke University recently published an excellent paper exploring “The Best Strategies for Inflationary Times.” Their analysis of the historical data, presented below, confirms our intuition: a diversified trend following strategy is one of the few reliable performers during inflationary periods.
Source: Neville, Henry and Draaisma, Teun and Funnell, Ben and Harvey, Campbell R. and van Hemert, Otto, The Best Strategies for Inflationary Times (April 28, 2021). Available at SSRN: https://ssrn.com/abstract=3813202.
The Oxford investment team strives to assemble robust portfolios enabling clients to compound enduring wealth. This effort results in a healthy allocation to diversifying alternative strategies, such as trend following, that serve to insulate portfolios from various macroeconomic environments, including inflation.
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*As of 10.1.20
**As of 12.31.19